So you have a business debt that your creditor has forgiven. That means you have cancellation-of-debt (COD) income. But, you asked, is it also subject to self-employment tax? And the answer is: maybe. Under Sec. 61, unless the income falls under a specific exclusion, COD income is always income for tax purposes. To determine whether any portion is also subject to self-employment tax, you need to look at your specific facts. And the best way to do that is to talk to your tax professional. But if your COD income is excluded under Sec. 108, there’s no income left to tax in the first place, so it’s there that an owner should focus. We’re a debt settlement firm, not a law firm or an accounting practice, so that last part is genuinely a job for your preparer.
You don’t have to send your creditors a check to get Cancellation of Debt (COD) income. It can happen if you change the terms of an existing loan, or if you pay with stock or other equity instead of cash. It can happen if a person related to you buys your debt for less than the amount due. It can happen if the creditor forgives the debt in bankruptcy. It can also happen if they forgive it without bankruptcy. It can also happen if the creditor forecloses. (In that last case, you can also make a separate gain on the asset as well.) Unless one of the exclusions in Sec. 108 applies, all of it is taxable. Does that sound harsh? It is, but that’s how taxes work. We think you should always expect the maximum tax bill based on current law. If you get a break, then it’s a nice surprise. So the real question is whether the debt cancellation falls under one of those exceptions. Four come up again and again for operating businesses: bankruptcy, insolvency, debts that would have been deductible if paid, and purchase-money debt reductions.
The Bankruptcy or Insolvency Exclusions
Start with bankruptcy. If the debt is forgiven and you’re in bankruptcy (under Title 11 of the U.S. Code), then you don’t have to pay any income tax on it. That’s right. If you have a corporation and it is the entity that owes the debt and gets discharged, you can exclude the income. Partnerships are different, and that includes an LLC taxed as one. What if a partnership goes through bankruptcy? It’s not tax free unless the individual partner is in the bankruptcy.
An insolvency exclusion limits your cancellation of debt income, while a bankruptcy exclusion eliminates it completely. If a company is insolvent immediately before its debt discharge, it can exclude the income resulting from the discharge, but only to the extent that it was insolvent. “Insolvent” means the difference between a company’s debts and its fair market value of assets. It may seem that the amount of insolvency could be inferred from the share dilution, but that’s not necessarily true. Let’s take a company with $500 million of debt that realises $100 million in COD income as a result of a workout. A valuation immediately after the workout gives the enterprise value of the company as $450 million. This means that it may have been insolvent by as little as $50 million, so only $50 million of the $100 million is eligible for the insolvency exclusion. It’s important to know the methods and assumptions used in such a valuation. The figures are huge, but the logic is the same for a small shop: you cannot simply assume how insolvent you were.
The partnership rule shows up here too. If your business is taxed as a partnership, you can’t exclude the COD income unless you (as a partner) are insolvent yourself (Sec. 108(d)(6)). And there are cases where you can count part of the partnership’s debts to figure out whether or not you are insolvent (Rev. Rul. 2012-14). And in either case, the exclusion for cancellation of debt income under the bankruptcy or insolvency exclusions is generally a timing item, meaning that instead of recognizing the income it is deferred by reducing the taxpayer’s tax attributes (Secs. 108(b) and 1017).
Tax Attributes
The taxman still gets his pound of flesh. He makes you take the benefit of the canceled debt and pay for it by reducing your “tax attributes.” You’ll reduce them in this order: You start with net operating losses, and then you take off dollar for dollar. You go next to general business credits, which you reduce at a rate of 33 1/3 cents per excluded dollar. Then it’s minimum tax credits, also at 33 1/3 cents per excluded dollar. Then you’ll take off capital loss carryovers dollar for dollar. Then comes basis in property, also dollar for dollar. Then it’s passive activity loss and credit carryovers, again at 33 1/3 cents per excluded dollar. Finally, it’s foreign tax credit carryovers, also at 33 1/3 cents per excluded dollar. Don’t worry, he doesn’t take your attributes until after he calculates the tax for the year of the discharge. That means you can still use your NOLs and other attributes for the rest of the year. If you are reducing NOLs, current year losses go first, followed by the oldest NOLs.
There is some flexibility in that order. Rather than starting with NOLs, you can choose to reduce the basis of your depreciable property first. That might be a good strategy if you have a lot of long-term assets like 39-year property and you expect to use your NOLs pretty quickly. Just remember, though, there are those Sec. 382 limits you need to watch on your post-restructuring NOLs. If you don’t make this election, your basis can never drop below your total liabilities right after the restructuring (Sec. 1017(b)(2)). Whatever excluded income is left after that doesn’t need any more attribute reduction. We call that “black hole” COD income.
The last two exclusions get less attention, but they can matter to a struggling business. Ever had a bill forgiven? If the bill you were going to pay was for something that would’ve been deductible, the cancellation isn’t taxable. It doesn’t trigger attribute reduction, either. If you’re a cash-basis business that hasn’t yet taken the deduction for a debt that’s now forgiven, there’s no cancellation-of-debt income. On the other hand, if you’re an accrual-basis business that did take the deduction before the debt was cancelled, you do have cancellation-of-debt income.
You buy something. You sign a promissory note to the seller. Later, the seller forgives some of the note. You don’t have income? That’s right. In that situation, the forgiveness reduces the buyer’s basis in the property, rather than creating COD income (Sec. 108(e)(5)). This statute only applies to buyers who are solvent and aren’t in bankruptcy. For insolvent or bankrupt partnerships, the IRS says they will allow the exclusion if all of the partners treat it consistently with the partnership (Rev. Proc. 92-92).
So, back to the question in the title. Cancelled business debt is income unless an exclusion takes it out. This can be a major tax hit if there’s no way to exclude it under Sec. 108. The two biggest exclusions are the bankruptcy exclusion and the insolvency exclusion. They’re alike, but different enough that you need to know which one you qualify for. And choosing either means you’ll have to give up some of your other tax savings in exchange. Whether any taxable piece also draws self-employment tax is something to settle with your preparer, using your own facts. Either way, the tax issues involved should come up with your tax advisor as soon as possible and not a week after a debt settlement is closed.
